The In’s and Out’s of Exchange Traded Funds
Monday, 3. August 2009
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In the investing world, exchange traded funds (ETFs) are the latest and greatest. Although they have actually been around for more than ten years it is not until recently that the explosion of ETFs has occurred.
ETFs are a group of stocks that trade on the stock exchanges as if they are one stock. Generally in the past they have tracked a particular index such as the Dow Jones Industrial Average or the NASDAQ-100. Recently, however, they are forming ETFs that have a particular characteristic in common: they invest in a particular region or sector of the market, or have a certain market capitalization.
There are many advantages of ETFs over open and closed mutual funds. They can have a low cost of obtaining since you are paying a commission just like when you purchase individual stocks. If you use a discount brokerage, you can buy for very little money. The ongoing maintenance fees for an ETF are also minimal compared to actively managed mutual funds, and in some cases lower than index mutual funds.
Because ETFs trade like stock they have liquidity. With a simple phone call you can buy or sell. ETF exchange traded funds are priced every 15 seconds and trade continually throughout the day. This is not like mutual funds because mutual funds are only bought and sold at the end of the day. Since the ETF will be held in a brokerage account, it is easily traded.
Tracking an index means less selling within the fund. This makes for a tax efficient fund. ETFs rarely declare a capital gain. You choose when to sell and, as a result, you determine when you pay the taxes.
Index and actively managed funds retain a portion of their investable assets in cash. This is used to pay someone who is selling their fund. Since ETFs trade like individual stocks on the open market there is no need to retain a portion in cash.
There is no room for style drift in an ETF. In a managed fund, they might say it’s a large cap fund, but in reality they might chase performance by investing in small or mid cap funds. ETFs are required to maintain a 99% correlation with the index or basket of stocks that it represents.
Regarding ETF trading strategies, because ETFs trade like individual stocks you have the additional features of stock. ETFs can be sold short or on margin. For buying and selling, they can have buy, limit and stop loss orders. Put and call options can be purchased and sold using ETFs.
There are some disadvantages to exchange traded funds as well. They are not an appropriate investment to use with dollar cost averaging. If you have to pay a $10.00 fee each month when you make that $50 or $100 investment it can be difficult to make up that fee.
With the explosion of ETFs you have to watch what the fund is using as its underlying stocks. Sometimes it can be such a narrow focus that you really are not achieving diversification.
Because trading can be easy, you can get sucked into risky strategies. If you take part in market timing or short term trading, it can result in big losses. Puts and calls, or buying on margin when buying and selling ETFs, is riskier than buying and holding.
Exchange traded funds are the right choice under certain circumstances. For your main holding, you can use a broad index ETF. This can be complemented with ETFs that are targeted to provide weighting in a sector, region or type of market capitalization. As always know what you are investing in and be sure that it fits in your portfolio.
